2010 Sample Exam Version 2 Q#29 Here we have a swap paying float and receiving fixed. Our swap has negative market value. Which is the best way to terminate this swap? A. Settle in cash B. Enter into a payer swaption C. Enter into a receiver swaption The answer is A. But what’s wrong with B?
Think about it from an administrative back office perspective. If you settle in cash you will have completely removed the swap from your books, which is what you want. Settling in cash is superior to simply entering into an offsetting swap because if you offset it with another swap you will have to receive and make payments each period on the swaps. Administratively this is not ideal, as you would be responsible for managing all of the cash flows from now until the swaps’ expration dates. Also, realize that swaps are traded over the counter, and they are not typically exchange traded (yet!). If this were a future for example it could be ideal to enter into an offsetting position. However, as this is an OTC instrument, the ideal solution would be to simply settle in cash rather than bothering with receiving and making cash payments from now until the swaps’ expriation.
Thanks Vroooom. I got fooled into thinking that since swaptions are used to terminated swaps and have their own dedicated LOS, the test answer should be something related to swaptions.
Key word is terminate, not just offset the cash flows. Also, a swaption would not be ideal to even offset, since it would not kick in immediately. Additionally, it would also have to be an off-market swaption, if rates have moved (original swap has negative value), to get the cash flows to offset correctly.